Tax-Sheltered Savings

June 1, 2003

An overview of tax-sheltered investments

There's never been a better time to invest for retirement or education, thanks to the numerous tax-sheltered (or tax-advantaged) investments available today.

Tax shelters are investments that are given advantageous treatment by Congress. In the past 10 to 15 years we have seen some very significant legislation affecting two areas in particular: qualified retirement plans (which are eligible for favorable tax treatment under legislative and tax codes) and education plans.

In this issue, we'll look at the tax-advantaged retirement plans; next issue, we'll cover educational savings programs and take a look at how proposals from the Bush administration may favorably affect tax-advantaged savings in the future.

Change in philosophy

Today's tax-advantaged savings opportunities stem from a cultural change in America. During the first half of the 20th century -- starting in the Roosevelt era -- Americans expected the government or their employers to take care of their retirement needs. (Think Social Security, Medicare, and traditional pension plans.) It was a trend that continued up until the 1980s.

At that point, our society began to understand the huge costs of supporting these programs, and we began moving toward a more free-enterprise type of culture in which people are expected to care for themselves. With medical insurance, for example, copays and deductibles are more prevalent. Retirement savings have changed in a similar way. Workers can no longer simply assume that their employers are putting money aside for them; they understand their companies are contributing to their retirement savings on a matching basis.

Legislated opportunities

With the changes in the tax codes, our legislators are telling us, "You have to take some leadership in what you want and what you are going to receive for retirement. Let us find a way to allow you to put away money - on a tax-deferred basis -- to fund your retirement, or at least to supplement it."

There are many ways in which you can benefit from tax-sheltered, qualified retirement plans:

  • The contributions that you make to the plans are deductible, saving you 15 to 45 percent up-front on your tax bill.
  • Limits on contributions have been raised in most plans, meaning you can shelter more money. Current legislation allows not only for higher dollars to be contributed by high-income earners, but also higher percentages of that income.
  • Plans can now be weighted to benefit older and/or more-highly compensated participants -- particularly helpful if you are the owner of a practice or nearing retirement age.
  • You are not limited to participation in one plan. If you have income from a part-time position (in addition to your primary position), or if your spouse has an income, you may be eligible to participate in multiple qualified plans.
  • Qualified plans offer the best of both worlds. You don't have to give up investing in stocks, bonds, bank investments, or real estate. You can take a qualified shell and put under it virtually any other type of investment that you are comfortable with and knowledgeable about.

Doing more for less

You may have been reluctant to start a qualified retirement savings plan for your practice and your employees because of the administrative costs involved. While there may have been justification for this concern in the past, there's little validity to it today.

Although plans today are much more complex than they were even 10 years ago, the efficiencies of technology have dramatically driven down the cost of administration and calculations. Third-party administrators can now do a lot more work with a lot fewer people. Increased competition has meant more consolidation in the industry, which has also reduced costs.

Are there strings attached to these investments? Of course. There are limits on how much money you can put away -- but those limits have been dramatically raised. There are also restrictions on when you can take out the money, and you may have to pay penalties if you try to withdraw funds prematurely.

But don't let those considerations -- or your skepticism about government benefits -- prevent you from taking advantage of these opportunities. In my opinion, there is simply no investment that can compete favorably with a qualified plan. Because they have so many legislative enhancements, they cannot even be compared to other types of savings.

Which is best for you?

You'll find several different categories of tax-advantaged retirement plans in the market today. When choosing a plan, you'll want to consider the contribution limits and whether a plan can be weighted in favor of higher-income or older participants. This is not a job for amateurs. Unless you are prepared to spend the time to develop the necessary expertise on each type of plan -- and to keep up with changes in tax law that affect them -- you should consult with your tax and investment professionals to see which plan would be most beneficial to your particular situation.


Here's a quick overview of the plans available today:

Defined benefit plans. This type of pension plan promises a specific benefit at retirement -- for example, 50 percent of the salary earned during the five years before a person turned 65. The plan must be properly funded each year to ensure that the promised benefit can be paid. At present, the maximum benefit allowed is 100 percent of salary to a dollar limit of $160,000 in 2003. These plans offer the possibility of high yearly contributions to fund these benefits.

One of the most flexible and attractive plans for physicians in private practice is a 412(i) fully insured defined benefit plan. This plan is ideal for owners of small businesses with few or no employees. It is constructed entirely from life insurance and annuity products so that plan benefits -- which can be significant -- are guaranteed by a life insurance company.

A 412(i) plan is funded entirely by an employer, whose contributions are tax deductible (reducing and deferring income taxes). It allows much higher maximums on contributions -- up to $332,000 per year.

Employer contributions to the plan are more stable and predictable than those in some other types of qualified plans. Plan administration is simpler as well.

Profit-sharing plans. If you're uncomfortable with the idea of mandatory contributions to a retirement plan each year, consider a profit-sharing plan. These are qualified plans in which the contribution varies from year to year. The business does not actually have to make a profit to make a contribution to the plan. On the other hand, in some years an employer may choose not to contribute at all. There are no guarantees of benefits, which will depend on the return on investments made from contributions.

Traditional profit-sharing plans allocate contributions for each employee in proportion to their salaries. If an employer contributes 5 percent of all eligible employees' compensation to the plan, then each eligible employee will receive an allocation of 5 percent of his compensation.

But new regulations allow different types of weighted contributions: Under age-weighted plans, older participants receive larger contributions, as a percentage of their salary, than their coworkers.

A comparability profit-sharing plan is the most flexible of profit-sharing plans and allows a business owner to allocate contributions according to classes or groups. The groups can be based upon salary levels, age levels, service levels, or a combination of these.

With 401(k) profit-sharing plans, employees can make tax-deferred contributions to their retirement fund in addition to the contributions made by their employers. A safe-harbor 401(k) profit-sharing plan requires some minimum contribution by the employer for all employees, but it also allows highly-compensated employees to contribute more to their own plans. The contribution levels of non-highly compensated employees do not limit their own level of contributions.

Money purchase plans. Finally, if your retirement plan is based on a money purchase plan, it may be time to take another look. Before 1991, in combination with a profit-sharing plan, they offered one of the few ways of putting additional money away in a tax-effective way.

Changes in tax codes, however, have turned these plans into virtual dinosaurs. Today's profit-sharing plans can accomplish the same thing as the money purchase/profit-sharing plan combinations, and they offer greater flexibility and easier, less-costly administration.

For the record, money purchase plans include target benefit plans (which, like a defined benefit plan, targets a certain benefit at retirement); S.I.M.P.L.E. IRA plans (which allow tax-deferred contributions by employees in addition to employer contributions); and SEPs (Simplified Employee Pension plans), which are similar to traditional Individual Retirement Accounts (IRAs) but with higher contribution limits.

If you already have a money purchase plan, talk with your tax or investment adviser about the benefits of terminating it and taking advantage of one of the new types of plans.

The legislature has done its job -- there are many tax-advantaged plans out there, and they offer greater flexibility than ever before. Now it's up to you (and your financial adviser) to find ways to use the advantages in a creative manner. If you are a high-income earner, and/or age 50 or older, the enhancements that you can build into a qualified retirement plan are truly amazing.

Trevor C. Lewis Jr., CFP, can be reached via editor@physicianspractice.com.

This article originally appeared in the June 2003 issue of Physicians Practice.